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Short-Term Reversal Strategy Still Outperforms The Market

May 05, 2020 2:21 PM ET14 Comments
Opportunity Trader profile picture
Opportunity Trader


  • The short-term reversal anomaly in stocks has persisted over the past 20 years.
  • A simple rotational strategy can be used by investors to benefit from this stock market anomaly.
  • A historical backtest of this strategy offers insight in the risk/reward profile of the strategy.

As the stock market is currently rallying up again after the COVID-19 correction, investors are analyzing whether now is a good time to make an investment in stocks.

Unlike passive investors, who prefer to invest in large stock market trackers, certain investors prefer a more active approach.

In this article, we will have a look at a stock market anomaly called the "short-term reversal strategy", in which funds are being allocated into stocks which have declined strongly over a short period of time. The positions in these stocks are then closed after a brief period of time and the funds are allocated again to the weakest performers.

By basing investment rules systematically on this stock market anomaly, investors would have outperformed the stock market significantly. We will go through the results of this strategy and present a simple rotational strategy which can be implemented by traders to benefit directly from this anomaly.

Historical research of the reversal anomaly

Short-term return reversal in the stock market is a well-established phenomenon, which has been researched in depth by academicals. For example:

  • Jegadeesh (1990) documented profits of about 2% per month (or 24% annually) over the period 1934-1987 by using a reversal strategy buys the worst-performing stocks over the past month and holds these stocks in the portfolio for one full month.
  • DeBondt and Thaler (1985) look in-depth at this phenomenon and argue the reversal effect can be explained by over-reactions to information in the market
  • De Groot et al (2011) investigate a simple mean reversion strategy in US stocks (based on the anomaly) and propose the implementation of a more sophisticated portfolio construction algorithm to lower the turnover and trading costs of the strategy.

While most of the historical research tends to agree on the existence of the short-term reversal anomaly, they

This article was written by

Opportunity Trader profile picture
I'm an independent trader with an interest in identifying unique trading opportunities. I'm passionate about the markets and like to look for trades with an asymmetric risk/reward profile. The assets I follow range from common stocks, options, ETF's, futures to FX derivatives. I hold a Master of Science degree in Applied Economics, with a major in Finance and have been working as a Finance specialist in multiple industries.

Analyst’s Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.

Seeking Alpha's Disclosure: Past performance is no guarantee of future results. No recommendation or advice is being given as to whether any investment is suitable for a particular investor. Any views or opinions expressed above may not reflect those of Seeking Alpha as a whole. Seeking Alpha is not a licensed securities dealer, broker or US investment adviser or investment bank. Our analysts are third party authors that include both professional investors and individual investors who may not be licensed or certified by any institute or regulatory body.

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Comments (14)

May I ask which screener you use to select these companies?
Opportunity Trader profile picture
@JOKA18 I use Amibroker, but you could also manage it with the stock screener from Finviz.
Can I just clarify that you are buying at the buy price and selling at the sell price? The only issue I see from where I am in the UK is finding a broker that would charge $1 per transaction (the average being £10). The alternative would be to do this via spread betting but the average spread on the S and P 100 is about 0.2%, which equates to a $4 cost for each buy and sell trade (with additional daily finance costs) when the first buys are at $2000. Obviously with spread betting they would get much larger as the equity increased. Any suggestions on how one could achieve a transaction cost of $1?
@neilsmith3737 I imagine you found an answer Neil, but for low/free commissions check out Trading 212, Freetrade, IG, eToro, DeGiro, Stake. Maybe others too but the first three here at least have UK tax wrappers (ISA/SIPP). Otherwise, US/other brokers might allow you to open an account and fund with $. Some things to consider, off top of my head only: Currency risk, W-8BEN form, currency exchange fees, platform fees, spreads.
A very interesting read. I wonder if you have also considered shorting the 5 best performers in the same time frames?

If shorting the best performers is also profitable as a standalone strategy, it would help even further when combined with your strategy by minimising overall drawdowns due to market crashes?
Opportunity Trader profile picture
I have not backtested any short trades, but I would assume this to be rather risky. The best/worst performers of the S&P100 index tend to be highly volatile, shorting the stocks would create huge volatility for your overall portfolio. I will keep it in mind to run the backtest though.
Hoping someone can answer this easy question: How do you handle the portfolio once you make the investment in the 5 worst-performing. If you have 10,000, and 5 stocks that fulfill your buying rule, then you have 2,000 in each stock. Let's say one stock sees an increase in price and the 2,000 dollar investment increases to 3,000 and takes it out of the 50 worse performers. Then you would sell the stock and have available equity is 3,000. What do you do with that money? How do you choose the new stock to take its place? Do you have several portfolios? I am pretty sure I am just misunderstanding the strategy, any clarification would be great! Impressive results!
Opportunity Trader profile picture
@lkanaskie The idea is that you would determine your equity at the end of the week. In your example, let's say 1 stock increase from 2k to 3k, and the other 4 stocks remained at 2k. At the end of the week, your new equity would then be 11k. This means on Monday morning you should ensure your new stock purchases would have an investment allocation of 2.2k (=11k/5). Each new purchase should be made for 1/5th of the current equity.
Okay, thank you that makes sense. One additional question: If the other stocks do not break out of the 50 worst-performing stocks, then isn't the available equity just the money you have from the one stock sale (3k.) Or are you selling all of the stocks Monday and just buying them again if they are still in the 50 worst performing?
Opportunity Trader profile picture
You should then calculate the new equity (at the end of the week) as the sum of the total value of each long position you have in each share. In this case 2+2+2+2+3 = 11 (this is the total equity). If you would keep the first 4 stocks you can keep their asset allocation at 2k, there is no need to first sell them and then repurchase them for 2.5k. You could sell all your positions weekly, this would leverage your results even more, but in this backtest I just kept the equity allocation at 2k until they are sold.
Please let me know in case you would have any additional question.
own_account profile picture
I usually trade delta neutral option trades so the volatility of returns associated with this puts me off. But investing a small part of my portfolio in it and letting it run is a trade that wouldn't keep me awake at night and has promise of paying off. Maybe switch your bit coin or gold allocation to this.
Opportunity Trader profile picture
In case you like option trades, the system mentioned in the article here above is pretty good at locating high volatility trades (to structure long straddles-strangles). Just an idea for thought ;-)
What about a stop loss? Did you backtest the strategy with some kind of a stop loss?
Opportunity Trader profile picture
Hi Dsertov, the issue here is that a stop-loss would cut short most of the winning trades. I ran similar situations with a stop loss, but technically speaking a lot of the winning trades have a high MAE (maximum adverse excursion) before they come winners. A simple stop-loss order would not grant enough breathing room for the winners to materialize.
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